Thursday, November 8, 2012

Recency Bias and Investor Returns

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

David Winters is the portfolio manager of the Wintergreen Fund (WGRNX). He was recently interviewed by Consuelo Mack. In the interview, Winters had this to say:

"...people think it's been such a bad period for 10 years that this is going to be forever...and the only way to have made money was, except certain well-selected securities, has been to own bonds. So people now have their money in...Treasury securities."

Winters also makes the point that purchasing power shrinks over time:

"People lose purchasing power on a daily basis. I think inflation is very real. You have food prices going up, fuel prices going up. You need to get your hair done. Prices go up, and if you have your money not growing over time, you get crushed. So here you've got the public believing and institutions believing equities are dead."

Also, Treasury securities may be perceived as safe but, he added:

"We think what's perceived as a risk-free asset is actually an incredibly risky asset."

And finally...

"...if you own the right businesses with a global footprint that grows free cash flow, has a nice yield, those businesses become more valuable over time, and they have the ability not only to raise prices but to sell more units, and so the well-selected equities, which is what we do at Wintergreen Fund to the best of our ability, it protects you from inflation, the erosion of principal which is really, I think, the biggest risk out there."

There's a reliable tendency for investors to be drawn into what has worked recently. In the late 1990s, investors were buying expensive stocks because that's what had been working. These days, investors are drawn into expensive bonds because that's what has been working.

The rear-view mirror is a useful thing to have in an automobile yet no driver can afford to ignore the windshield for very long.

It's no different for investors but, because of recency bias -- the tendency to project recent experiences as if they'll continue into the future -- the equivalent tends to happen. A particular type of asset may seem not risky because of recent performance. Yet, even the highest quality asset that's relatively low risk at one price becomes quite risky (as measured by the possibility of permanent capital loss) when it sells far above its intrinsic value.*

Many stocks sold for 40 times earnings (and, in the case of many tech stocks, much more) in the late 1990s. That's incredibly expensive by any standard and a tough way to get satisfactory risk-adjusted long-term returns on shares of even good businesses (there are exceptions, of course) never mind subpar businesses.

Today, in contrast, it's not tough to find shares of a good business selling for 15 times earnings and even much lower (and, if it's a higher quality business, that stream of earnings should be increasing for many years to come). 15 times earnings may not be extremely cheap but at least it provides a much more favorable environment to buy. Of course, it's certainly possible for the earnings multiple of even the best business to continue contracting. Yet, that's hardly a problem for an owner that has a long horizon. In fact, it's actually a net benefit since the company can use its cash to buy back shares cheap (the same amount of cash reduces the share count by a larger amount directly benefiting the shareholders who hang in there long-term).

If a business has durable advantages, eventually the underlying business economics determines value and the price should, in the long run, at least mostly, if not completely, reflect it. Price action to the downside may feel unsettling but, at least for shares of a good business, it logically shouldn't be. For the long-term part owners of a good business, it's actually quite advantageous when a stock drops even further below what it is intrinsically worth.

The important thing for investors is that the stock is bought below what the business is intrinsically worth per share in the first place (margin of safety).

Now, unlike common stocks, a Treasury security offers the promise of getting your principal back at maturity. Understandably, that's front of mind for many investors considering recent experience in the capital markets, but it's worth considering how recency bias becomes, at times, very detrimental to investor returns.  Even just some awareness of this particular cognitive bias can help an investor avoid the costly misjudgments associated with it.

An investor who accepts a 2% yield from a Treasury security is effectively paying 50 times "earnings" (the annual coupon payments). Importantly, unlike a good business, those earnings can't increase in a way that keeps up with inflation.**

Capital preservation is always important but, in the long run, it's going to be tough to maintain purchasing power (never mind increase purchasing power) when an investor pays 50 times or more for an asset that cannot increase the income it produces over time. Sure bonds prices might continue to rise (and yields fall) but compensation for an investor -- at least those with a longer time horizon -- will be likely be inadequate considering the risks. It's less than ideal when returns are dependent on the willingness of other market participants to pay an extreme price. An investor in a pricey bond has to hope someone else will be around to buy it when an attractive alternative investment opportunity comes along.***

Otherwise, it is either take a capital loss or, "best case", forgo the opportunity and collect that inadequate coupon until maturity as purchasing power is eroded year after year by inflation..

In a recent Morningstar interview, John Bogle talks about the trend toward speculation and gambling over investing. In the interview, he point to the late 1990s...

"...where the price of the stock became more important than the intrinsic value of a company. And when you focus on prices and pretty much disregard intrinsic values, you are just gambling."

In contrast, when an investor pays a fair price to own part of a business long-term, they're interested in what the asset can produce over time (the underlying economics that determine intrinsic value), not whether price action happens to go the right way. Since the intrinsic value grows faster than inflation, purchasing power isn't just maintained, it increases.

John Bogle later added just how much this trend has crowded out investing:

"...if you call investment fulfilling the basic function of the financial system, and that is directing capital to its highest and best uses, you're talking about money [that] gets directed in new ventures, existing companies, innovative companies, whatever it might be. And that has been running about $250 billion a year. How do you measure speculation? [You do so] by the amount of trading that goes on in the market, and that's around $33 trillion a year."

The simple math means that 99.2% of what's happening in the market is speculation and .8% is an investment. Consider that the next time someone argues the market needs sufficient liquidity. Speculation is just fine and even desirable but, as with any system, proportion matters. We've got plenty of liquidity. What we need is more actual investing.

Investing to achieve favorable long-term outcomes is rarely easy and naturally has its fair share of risks. Yet, that it is inherently challenging shouldn't lead an investor logically to either speculate on near term price action or hide in Treasury securities.

For those with a long-term horizon, many far more attractive investing alternatives exist.


* See Berkshire's owner's manual for a useful explanation of intrinsic value.
** 10-year Treasury notes are at 1.67% as I write this. So they currently sell for nearly 60 times the interest paid annually.
*** The same is obviously true with a pricey stock but here the option to just hold to maturity in order to get your principal back doesn't exist.
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